S&P 500 ETFs Prepare For Berkshire Addition

Coming soon to an ETF near you: Warren Buffett. Well not exactly, but shares of Berkshire Hathaway, the company run by the “Oracle of Omaha” will soon be included in the S&P 500 Index and find a home in many of the most popular large-cap and all-cap ETFs.

Back Story

Berkshire is one of the largest U.S.-listed public companies (it claimed the 13th spot in the 2009 version of the Fortune 500), but has long been excluded from the S&P 500 due to concerns about the stock’s liquidity. Berkshire has never recorded a stock split, causing the company’s stock price to climb by consistently generating profits. Shares of Berkshire crossed $100,000 for the first time in late 2006 and climbed as high as $150,000 in December 2007. Average daily volume for Berkshire’s A stock (BRKA) is only about 1,000 shares. Berkshire management has cited its desire to attract long-term investors in favor of short-term speculators as reasoning for refusing to split shares.

But when unit trusts investing in Berkshire stock began to pop up, Buffett relented by creating class B shares that had a per-share value kept close to 1/30th of the class A shares with 1/200th of the per-share voting rights. With a per-share value above $3,000, trading in these shares was still on the light side, with three to five million shares changing hands daily (compared to 75 million for GE and 25 million for Exxon).

Last week, Berkshire conducted a 50-for-one stock split of its class B shares, sending the price to around $70 per share and trading volumes through the roof. Late Tuesday, Standard & Poor’s announced that it would finally add Berkshire to the S&P 500 Index. Berkshire shares surged on the news, as investors anticipated a rush of buying from index funds and ETFs.

Big Boost

The addition of a company to a widely-followed index has historically given shares a boost, but this impact has been magnified significantly in recent years with the rise in popularity of passively-indexed ETFs that generally strive to track the movements of an underlying index within a few basis points.

But Berkshire is a special case. The addition of a company to the S&P 500 generally coincides with its removal from benchmarks measuring the performance of smaller stocks (e.g. the S&P MidCap 400). The net effect of this upgrade is generally a positive one (since the S&P 500 is a more widely-tracked benchmark than its mid-cap counterpart), but any surge in demand is partially offset by sales from other funds.

But instead of shifting from fourth gear to fifth, Berkshire is essentially going from zero to sixty. Currently not included in any major benchmarks, the stock will soon be one of the largest components of one of the most widely-followed index in the world. By many estimates, Berkshire could make up about 1.1% of the S&P 500 (Buffett’s personal holdings significantly reduce the public float used to determine S&P weightings). The S&P 500 SPDR (SPY) and iShares S&P 500 Index Fund (IVV) have aggregate assets of over $100 billion, meaning that ETFs alone will be buying more than $1 billion in Berkshire stock. Between broad market funds, mega-cap ETFs, value spin-offs, and various fundamentally-weighted alternatives to the S&P 500, several funds are facing some significant rebalancing acts in coming months.

Index reconstitution can have some interesting effects. Last year, Israeli equity markets actually fell following an announcement from MSCI that the country had been upgraded to “developed” status. While the upgrade reflected improvements in the quality of Israel’s capital markets and was an endorsement of local markets to international investors, it also meant the eventual sale of all stocks listed in Israel from several widely-held emerging markets mutual funds, index funds, and ETFs. Although this effect was offset somewhat by the inclusion of Israel in developed market indexes, the economy’s size relative to the U.S., Japan, and other developed markets translated into a minor allocation in funds.

Tracking Error Watch

Rebalancing is a regular part of ETF management, but most reconstitution efforts are significantly smaller in scale than the challenge facing several ETFs that must now add Berkshire to their holdings. With this undertaking, the potential for tracking error in these funds increases considerable. The S&P 500 is a hypothetical basket of stocks, meaning that the index committee can reconstitute the benchmark with the flip of a switch and without incurring transaction costs. But ETFs like IVV and SPY must actually go out into the market and complete trades to achieve the desired find composition. For ETFs with hundreds of holdings, the impact on bottom line returns is generally minimal, but the Berkshire rebalancings promise to be unlike any before.

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